On 3 July 2017, the European Banking Authority (EBA) held a public hearing in London to update stakeholders on its progress in developing recommendations for the European Commission (the Commission) for a new prudential regime for MiFID investment firms.

The EBA’s work on a new prudential regime for investment firms is in response to a call for advice from the Commission in 2015. The EBA published its Report on Investment Firms in 2015 (available here). Following a second call for advice, the EBA published a response on the criteria that should be used to identify the classes of investment firms in October 2016 (available here) and a further Discussion Paper in November 2016 (available here) regarding the regime that should apply to each class of investment firm.

The slides from the public hearing are available here. They list 58 recommendations in respect of the new regime and key points to note include:

  1. Headline: The EBA’s proposed regime appears likely to leave overall capital requirements broadly unchanged with lighter touch regimes for liquidity, remuneration, governance, and reporting / disclosure for Class 2 and 3 firms.
  2. Categorisation: Existing categories such as full scope, limited licence and limited activity will be replaced with three new Classes. Class 1 will include Global and Other Systemically Important Institutions (G-SIIs and O-SIIs) and may yet be extended to cover other firms considered to be systemic. Class 2 will capture all other non-systemic investment firms, including all firms engaged in proprietary activity with asset managers and advisors being split across Classes 2 and 3. Class 3 will include small and non-interconnected investment firms.
  3. Capital Resources & Initial Capital: Existing CRR rules breaking down capital by quality as CET1, AT1 and Tier 2 are retained and, though expressed differently, the mix CET1 vs AT1 vs Tier 2 is also essentially unchanged. The EBA also recommends raising initial capital requirements for all categories of investment firms to €75,000, €150,000 or €750,000 depending on the type of authorisation. Dealing on own account and operation of MTF or OTF would automatically be subject to the highest initial capital requirement.
  4. Capital Requirements: Initial indications suggest that the quantity of capital that will be held by investment firms will be broadly consistent under the new regime though capital deduction thresholds will not be available. Class 1 firms will continue to apply the CRR (as revised by CRR II), with Class 2 firms calculating their requirements on the higher of initial capital (now referred to as Permanent Minimum Capital (PMC)), Fixed Overheads requirement (FOR) or risk-based “K-factors”. Capital requirements for Class 3 firms will be based on the higher of the PMC and FOR.
  5. K-factors: Following feedback, the EBA has modified some of the proposed K-factors and certain of the coefficients (which determine the importance of their corresponding K-factors). Risk to Customer (RtC) is proposed to be measured by five K-factors (asset under management, client money held, assets safeguarded and administered, income from giving investment advice and customer orders executed). For firms dealing on own account, two K-factors (net position risk and daily trading flow) will measure the Risk to Market (RtM) with a further two (trading counterparty default and concentration risk) measuring the Risk to Firm (RtF). The controversial uplift factor for RtF is replaced with the trading counterparty default factor.
  6. Calibration of Capital Requirements: The EBA’s 2015 and 2016 work suggested that capital requirements might be calibrated to cover only the orderly wind-down of firms. This is implicitly followed only for Class 3 firms as their regime rests on the FOR, though reference to this as a basis for calibration was absent at the public hearing. The EBA currently appears to use two reference points for Class 2 firms: a direct comparison with the regime for banks (despite the impetus for this process being the unsuitability of applying the banking regime to investment firms); and maintaining the current level of capitalisation (albeit focussed in a new fashion using the K-factors). The EBA indicated that calibration of daily trading flow K-factor for firms dealing on own account will be its major focus.
  7. Liquidity: Only Class 1 firms will be obliged to apply the Liquidity Coverage Ratio (LCR) but the EBA has not recommended applying the Net Stable Funding Ratio (NSFR) as this is still under development (so this might be anticipated in future). Class 2 and 3 firms should have internal rules to manage their liquidity needs ensuring liquid asset holdings of one third of the FOR, with Class 2 firms also subject to liquidity reporting requirements.
  8. Reporting: Class 1 firms will be subject to CRR reporting requirements. Classes 2 and 3 will have a simplified framework addressing key attributes such as solvency, capital requirements and composition, liquidity requirements, concentration risk, with additional metrics for specific business models. Reporting for Class 3 will be more simplified than for Class 2, including no obligation to report on concentration risk. Class 2 and 3 will also not be required to publically disclose their return on assets or maintain a dedicated website on corporate governance and remuneration.
  9. Remuneration & Governance: CRD IV remains the basis of the rules for all firms with Class 1 firms applying it in full. Class 2 and 3 firms will not need to apply requirements on management of various risks, including credit, counterparty, residual, concentration, securitisation, non-trading book, liquidity and excessive leverage risks. The EBA recommends partial application of CRD IV’s variable remuneration rules to Class 2 firms, though leaves a decision on the controversial bonus cap to the Commission. MiFID II governance and remuneration requirements will remain in full effect for all firms.
  10. Commodity dealers: The EBA proposes that all commodity firms that will be authorised as investment firms in accordance with MiFID 2 should be subject to the new prudential regime, subject to currently not specified adjustments reflecting trading activities objectively measureable as reducing risks directly related to commercial activities (hedging) and a phase-in period.

As for next steps, the EBA plans to request further data from firms in additional one-month data collection exercise (templates and instructions for data submission will be available here). It may yet conduct further industry engagement on calibration and, though the EBA will continue its normal dialogue with firms, there is to be no further consultation on the recommendations prior to their submission to the Commission. The EBA is expected to submit its final recommendations to the Commission by the end of September with a legislative proposal to be raised by the Commission during November.

For further information please contact Jonathan Herbst, Jack Prettejohn, Conor Foley, Anna Carrier or your usual Norton Rose Fulbright LLP contact.

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